Life Insurance-Bankers' New Best Friend

A power has risen up in the government greater than the people themselves, consisting of many and various and powerful interests, combined into one mass, and held together by the cohesive power of the vast surplus in the banks.
-- John C. Calhoun, Speech from 1836

The fun has not gone out of banking after all. Following the disastrous fall of 2008, conventional wisdom had it that many of the things that made banking fun, like amazing bonuses and fascinating (if not understood) financial instruments were going to follow the dinosaur into extinction. That, of course, did not happen. Bonuses are as big as ever and a recent announcement discloses that a new financial instrument that is far more interesting than a bundle of mortgages is about to hit the market. It involves life insurance.

For years life insurance was thought of as something to provide cash following its owner's death to be used for a variety of purposes ranging from the payment of taxes to providing funds for young families to replace the lost earnings of the parent who died. As families grew older, in many cases the need for life insurance diminished. Owners of those policies took advantage of the cash value in the policy and accepted that amount from the company in lieu of keeping the policy in force. Since the cash value the policy holder received was much less than what the company would have to pay were the policy in force at the policy holder's death, the insurance company was delighted to redeem the policy for its cash value instead of its face value.

Unfortunately for the insurance companies, a greedy group of people sprang up who said to policy holders that getting cash value from the life insurance policy was a rip-off. They offered to buy the policies for more than their cash value. The purchasers figured out how long the insured was likely to live and, adding in the policy proceeds payable at death, came up with a price they were willing to pay the insured. The insured, who no longer wanted the insurance, was delighted to have more than the cash value of the policy to spend before death. Sensing a good thing, Wall Street has figured out how to turn this practice into something that is even better than the collateralized debt obligations based on mortgages. (Those would have been a win-win situation for everyone if the unimaginable and unimagined had not occurred.) This latest financial instrument is a guaranteed win-win almost for sure. Here is how it works.

Assume that one thousand very old people all have $1 million life insurance polices with low cash values. Those people would not be tempted to cash in their policies for the cash value. Along comes a bank and agrees to pay each of them $700,000 for the policy. It names itself the beneficiary, begins paying the premiums and bundles the 1000 policies into a $700 million bond called "Death Pays" and sells interests in the bond to investors. If all the insureds die within 30 days, the investors will be thrilled because Death Pays will now be worth $1 billion, an increase in value for the investors of $300 million in 30 days. If, however, all the insureds take the money they got from selling their policies and go on a tour sponsored by AARP to a spa that has a treatment that gives them an additional 30 years of life, the holders of "Death Pays" will be less than thrilled. (Were that to happen the issuer of "Death Pays" bonds might hire hit men to accelerate events that would cause the policies to mature but that brings with it a completely different set of problems that are beyond the scope of this column to examine.)

Life insurance companies are not terribly happy with the idea that their policies will remain in force instead of being sold for cash value. If this new idea catches on, more and more of their policies will be bought and kept in force until the happy day the insured dies. Indeed, Kathleen Tillwitz, a senior vice-president at a firm that is rating 9 proposals for life-insurance securitizations from private investors told the New York Times that "our phones have been ringing off the hook with inquiries." An investment banker not authorized to speak to the NYT (or other media) who spoke to the NYT said: "We're hoping to get a herd stampeding after the first offering."

Some analysts say that this is a wonderful new product since death is not related to the rise and fall of stocks. They are right, unless a dramatic fall in the stock market is accompanied by falls from window ledges as happened during the great depression. If that were to happen the amounts owed by the companies on the life insurance policies could exceed the insurance companies' ability to pay, thus causing their insolvency and the need for a government bailout. Thanks to the sophistication of those constructing these new investments, that almost certainly will never happen.